Wall Street Journal Asia

China’s False Promises

Senior Fellow

A report in China's state-run Economic Information Daily last week suggested that Beijing will make the yuan fully convertible by 2015. The prospect that market forces will determine the value of the yuan within the next four years may lessen the pressure from foreign governments for immediate action.

The timing is certainly fortuitous. Finance ministers from the Group of 20 are scheduled to meet in Paris next month, and there are rumors that French President Nicholas Sarkozy wants to raise the currency issue.

However, Beijing has a history of pre-emptively making promises to deflect attention from the issue. The most recent case was a statement by the People's Bank of China (PBOC) that it would insert more "flexibility" into its exchange rate regime in June 2010—just prior to a meeting of the G20 in Toronto.

Back then, no target for the yuan's value was set and no time frame was given. Any "large-scale appreciation" was categorically ruled out. Indeed, over the last 14 months the yuan has appreciated only about 6% against an otherwise weakening dollar, meaning that in trade-weighted terms the yuan has barely appreciated at all.

Some observers are optimistic this time will be different. For one thing, the current announcement has an actual time frame. Moreover, officials from the PBOC are pressing for a floating yuan as part of the "rebalancing" of the economy toward domestic consumption detailed in China's Five Year Plan, which runs from 2011-15.

It would also help contain inflation, which is currently running at about 6.5%, considering China imports about half of its basic consumer goods as well as energy needs. Allowing the currency to appreciate would be one way of enhancing domestic consumption by increasing the purchasing power of its people.

We do know that when it comes to economic policy, the primary calculation is always based on what is needed to enhance regime security. Inflation was one key reason behind the countrywide protests in 1989. But China isn't seeing a repeat: Through a combination of price and credit controls and targeted subsidies today, current levels now are nowhere near the 18.5% in 1988-89.

Instead, Beijing sees a different economic malaise these days, one that has a different answer. Even though official unemployment is at a very manageable 4% to 5%, these statistics measure less than one-tenth of the population. Unofficially, well-placed bureaucrats in the Ministry of Labour and Social Security have indicated to me that unemployment could be at least double that. The figures also do not include the estimated 200 million itinerant workers who fall in and out of work constantly.

All this means that preserving jobs rather than macro-economic and structural rebalancing will remain the more compelling motivation. China's job engine so far has been manufacturing and the Party will be loath to push up the yuan and make those job-creating businesses uncompetitive.

More broadly, the problem is that Beijing still relies on the low-skill manufacturing model for growth. Here, the dysfunctional nature at the heart of the Chinese political economy explains the government's intransigence on the currency issue. For Beijing to even contemplate floating the yuan, it must first rebalance the economy away from a reliance on fixed investment and exports.

Given the understandable focus on employment, the conditions paving the way for genuine currency liberalization in China can only be achieved if China's vibrant domestic private sector takes the lead in creating jobs. The domestic private sector is twice as efficient as state-owned-enterprises in creating jobs. Yet, SOEs are favored over the domestic private sector. Starved of capital and blocked from market access in many sectors, the numbers of domestic private firms have actually fallen since 2008.

But the plan to allow SOEs to dominate key sectors of the economy was cobbled together from the mid-1990s onward as a response to the 1989 protests, to ensure that the Chinese Communist Party remains the primary dispenser of business opportunity in the country. To the Party, encouraging the rise of an independently wealthy middle class is a greater threat to regime security than macro-economic rebalancing.

This distorted economy and polity means that heavy reliance is placed on the export manufacturing sector, which is responsible for 150-200 million jobs. Little wonder that when the dollar was allowed to appreciate about 17% from 2005-2008, an estimated 20-40 million jobs were lost, causing Beijing to put an abrupt halt to the yuan's rise.

State-ordered stress tests of more than 1,000 export manufacturing companies in 2010 indicated that these firms were surviving on 2% to 4% margins. In addition to the fact that Beijing is attempting to gently deflate a property bubble by reining in bank lending for construction—the other big source of employment—leaders will not tolerate any engineered downturn in the export manufacturing sector.

Promises of full currency liberalization are designed to deflect American and European angst about China's currency policies ahead of the Group of 20 meeting next month. But Beijing is in no position to deliver.